Guest post: Why we need the European Central Bank as Lender and Owner of Last Resort

This post summarizes a short policy note where I argue that the only feasible as well as incentive-compatible solution to the current sovereign debt crisis in the Eurozone involves the European Central Bank (ECB)

as a Lender of Last Resort to the Eurozone’s core countries like France, Austria, Finland, and The Netherlands, and

as the Owner of Last Resort to the European banking system, thereby setting the stage for haircuts on the debt of potentially insolvent peripheral Member States like Greece, Italy, Spain, and Portugal.

The arguments for a credible commitment of the ECB to an unlimited swap line, promising to swap central bank liabilities for sovereign bonds with the aim to reduce liquidity premia, are well-known. So I won’t repeat them here. I will rather focus on the second part of my argument, on the ECB as an Owner of Last Resort. As far as I am aware of, the idea is new. I guess the idea is fundamentally flawed in a way that I cannot see. This is the reason I wrote it down and why I thank Lars for making it available to a wider audience. Note, however, that I am full aware that the implementation of the idea is neither politically feasible, not is it legal (see the conclusion). My arguments are just concerned with economic admissibility.

The ECB as Owner of Last Resort

There are few economist who would deny that a haircut on sovereign debt is an incentive-compatible solution; the extremely serious downside is the risk of a breakdown of the European banking sector and global contagion.

But there is a solution. First, the European Banking Authority (EBA) should come up with serious stress tests, that is, predicting the impact of realistic haircuts on peripheral sovereign debt and of a Europe-wide recession on each Systemically Important Financial Institution (SIFI) in Europe. In a next step, the ECB should step in as the Owner of Last Resort and recapitalize each such SIFI according to the EBA’s projections. In contrast to its role as Lender of Last Resort, the ECB would swap central bank liabilities for preferred stocks, i.e., senior equity securities that carry no voting rights and, thus, prohibits the ECB from getting involved in the SIFI’s business models.

There are clear advantages of the ECB engaging as the Owner of Last Resort:

1. The most important reason why the ECB should engage in the recapitalization of the European banking sector is the same as usual: it can create unlimited amounts of central bank liabilities and, thus, unlimited amounts of premium-quality capital. The ECB as an Owner of Last Resort thereby avoids the vicious circle that any other realistic recapitalization scheme would trigger: if Member States like France and Germany are supposed to finance heavy haircuts on peripheral sovereign debt, their own solvency could be endangered, respectively; this would suggest even higher default probabilities and potentially higher haircuts on sovereign debt. In turn, Member States would have to get involved in a second recapitalization-scheme, which would endanger their solvency and credit ratings even further; the feedback loop would continue until the entire Eurozone eventually collapses.

The same is true for any other limited fund like the EFSF, which is eventually backed by France and Germany (IMF-financed recapitalization would in addition endanger U.S. ratings; neither the Obama administration, nor the Republican presidential candidates show any interest in increasing IMF-funds; also China refuses to support the EFSF). By contrast, the ECB cannot become insolvent. That such a situation is considered in its constitutions is only due to the fact that it is designed by lawyers, obviously unaware of the basics of central banking: what makes a central bank so special is that the unit of account in a at system is defined in terms of its liabilities, and that its liabilities are the used to redeem contracts. The monopoly producer of the means of final settlement just cannot get bankrupt, for bankruptcy happens if you lack the means to settle your obligations. Unconstrained by its constitution, any central bank can shield its equity capital against losses.

2. The approach is incentive compatible: it rescues banks, but punishes their owners. Given the increased quantity of SIFI-stocks, the share of profits generated by such financial entities that could be distributed to the private sector diminishes. In short, recapitalization is a blow to the return on capital invested, reducing the value of each stock in circulation as well as the value of newly issued stocks. This is why banks hate it, and why they negotiate insufficient haircuts. Thus, recapitalization by the ECB must be mandatory to avoid resistance by the SIFI’s managements – who are obliged by law to protect the interests of private shareholders.

3. The approach avoids deleveraging processes that otherwise will accompany the revisionof the the EU’s Capital Requirement Directive (CRD IV), which implements Basel III (in fact, CRD IV goes beyond Basel III). By cutting well-established credit lines to profitable companies, banks increase their capital ratio, respectively, by reducing the denominator. By contrast, the ECB as Owner of Last Resort would increase the numerator, leaving no rationale to deleverage. The consolidated balance sheet of the European banking system would lengthen instead. This ensures that (1) bank lending to the so-called “real economy” and (2) the transmission mechanisms of monetary policy remain intact.

4. Finally, and closely related to point 3, the ECB as Owner of Last Resort would back the possibility to implement significantly higher capital requirement over a horizon of ten to fifteen years. Research shows that high capital requirements are not detrimental to economic growth (See for example here). Instead, they ensure that systemically relevant institutions climb down the “Efficient Frontier” such that a lower return on capital invested is compensated by reduced risk. Ask yourself: Of all possible investments possibilities, why should systemically relevant institutions be the hotbed of relatively less risk averse or even risk-loving investors? All it needs is that the ECB injects more capital than projected by the EBA such as to ensure capital ratios around twenty or even thirty percent. In the aftermath of the crisis, the ECB would sell its preferred stocks during a period of ten to fifteen years, while commercial banks are prohibited to buy back these papers.

Conclusions

To contain the crisis, the ECB should act as a Lender of Last Resort, that is, it should credibly commit itself to an unlimited swap line as described above. However, to resolve the crisis the ECB should also act as an Owner of Last Resort with respect to the European banking sector and, thereby, set the stage for haircuts on the debt of potentially insolvent peripheral members of the Eurozone.

Of course, there is little hope that Germany will ever support such unconventional measures. It already brought France and Italy into line: they all announced not to seek for ECB intervention to rescue the Eurozone from a deepening sovereign debt crisis. But the problems with my proposal root deeper: it seems not only politically infeasible, but is clearly illegal. As an adherent to the Rule of Law, I feel highly uncomfortable with my own suggestions. Yet, I am not aware of an economically admissible solution to the sovereign debt crisis in the Eurozone that also conforms to law, including those measures I am opposed to. Given that the current legal framework does not support any feasible solution, and given that we do not have the time to adjust the legal framework, we will break the law anyway. Actually, we broke it already.

Perhaps is this the major lesson of the political project to impose a common currency on a non-optimal currency area: any attempt to implement a political vision in contradiction to economic regularities is not only doomed to fail, but also undermines the fundamental ingredient to a free and prosperous society: the Rule of Law.

—–
Note:
I am grateful to Arash for this very insightful comment on crisis resolution for the euro zone. We are facing an extremely challenging situation in Europe at the moment and if we do not move swiftly to resolve the crisis we could be heading for a disastrous outcome. I therefore welcome any discussion of this is issue and I would happily accept guest posts from other economists with an input to how to solve the crisis (please mail me at lacsen@gmail.com)

Finally I should say that I think that Arash’s ideas are very helpful in the terms of solving this crisis. That does not mean I agree with everything, but on the other hand there is certainly a lot of what Arash is saying that I agree 100% with. Furthermore, there is no doubt that the concept of Owner of Last Resort is theoretically very interesting and in my view the idea deserves more attention by other researchers.

9 Comments

Lars, I find thos article fascinating, very good. A very global analysis of the problem. I like the last sentence:

Perhaps is this the major lesson of the political project to impose a common currency on a non-optimal currency area: any attempt to implement a political vision in contradiction to economic regularities (some may say in contradiction to \economics laws”) is not only doomed to fail, but also undermines the fundamental ingredient to a free and
prosperous society: the Rule of Law.
Terrible

David Pearson

Lars,
Central banks have two unique attributes: they have irredeemable liabilities, and they have a monopoly over the supply of bank reserves. The litmus test for “monetary policy” should be, does the proposed action rely exclusively on these unique attributes? Being an “Owner of Last Resort” does not: it could just as easily be accomplished by the fiscal agent. What Vassei is really saying is, “the fiscal agent does not have the will or resources to recapitalize banks, so therefore the central bank should usurp this role.”

David, you might surely have a point there, but I will leave it Arash to answer this question. The great think about guest posts is that you don’t have to take responsibility for everything the guest blogger is writing-)

That said, as I see it nobody has come up with any great solution – and even though significant monetary easing from the ECB in my view could do a lot to solve this crisis I am not sure that that would be enough.

Arash

yes, I say exactly what you have summarized above. But why is it that fiscal authorities may not have enough funds (may become insolvent), whereas there is no doubt that the ECB always has the necessary fire power? This is something to do with the specific nature of central banks you and I describe above. I am not claiming that the ECB should act as OLR in all possible circumstances. You seem to suggest that fiscal authorities could do the job as well. In fair weather they can. Currently, however, I cannot see how fiscal authorities in Europe could mobilize sufficient funds to recapitalize the banking sector without risking a downgrade. Do you?

David Pearson

Arash,
I recognize the ratings downgrade dynamic is a problem. I don’t think the ECB is a solution, however. There are two possible outcomes. First, the ECB could swap Italian bonds in exchange for Excess Reserves. The effect of this action would be a contingent tax liability for European tax payers exactly the same as a Eurobond-financed EU purchase of Italian bonds. The question of whether the EU or the ECB should create this contingent tax liability is a political, not an economic one.

Second, the ECB purchases might create demand for bank reserves, in which case it would raise the price level — a favorable development for MM’s. However, this action could also be exactly replicated by: 1) the EU buying Italian bonds; and 2) the ECB financing the purchase by buying Eurobills issued by the EU. Again, the question of whether the ECB should purchase the bonds directly is a political, not an economic one.

In short, every argument for the ECB to engage in a fiscal action is an argument for the ECB to supplant the EU as a fiscal agent for Europe. This argument may have its merits, but they should be categorized as political merits rather than being passed off as economic ones.

what you describe in your example (i.e. ECB swapping Italian bonds in
exchange Excess Reserves) is about the ECB’s LOLR-function, not its
OLR-function. I’m quite clear in my paper that the ECB should contain
the debt crisis by acting that way … but not with respect to Italian
bonds, but with respect to bonds of the Eurozone’s core economies.

Anyway. Generally, there is a clear difference between the ECB and
fiscal authorities when it comes to acting as a LOLR. In contrast to
any other agency, the central bank can create unlimited funds. As I
argue in my paper, there is only one reason why we should expect the
ECB to engage in actual bond purchases: to establish credibility that
it will in fact make use of its unlimited fire power, if necessary.
Relatively limited purchases will suffice to eliminate unwarranted
equilibria. No other government entity can act like that, simply
because all such entities are budget constrained (or, equivalently,
must somehow “earn” or “receive” central bank liabilities by means
other than creating it “out of thin air”) and rule over limited funds.
Thus, it is not a matter of politics alone.

When it comes to the OLR-function, there may be a risk to the taxpayer
(even though the ECB could absorb any of its losses). But in contrast
to Eurobonds, the OLR-approach seems to be incentive compatible.
That’s an important “but”, don’t you think?

David Pearson

Arash,
The question is not what should be done but who should do it. I tried to point out that, no matter the asset purchased, a risk-asset purchase by the ECB is either 1) equivalent to a Eurobond-financed purchase of that same asset; or 2) equivalent to a Euro-bill financed purchase of that asset with the ECB supplying the funds. Thus, by arguing that the ECB carry out the action, you are basically saying, “the EU is unwilling to be the fiscal agent for Europe, and I propose the ECB take that role.” BTW, the EU as a whole is not “budget constrained”.

As far as the LOLR function is concerned, I believe it is different than what you claim. A central bank can perform LOLR because of its unique attributes (irredeemable liabilities, infinite supply of reserves). Both attributes allow this particular “bank” to supply liquidity to other banks when they are facing redemptions. The principal goal of proposed ECB purchases of bank preference shares and ECB financing of maturing Italian bonds is not to supply liquidity to the banking system. Instead, these measures are intended to reduce the credit risk premia of European debt, and reduce the corporate WACC of European banks. As Mervyn King recently said, this supposed “LOLR” function is (to paraphrase), “millions of miles away from the intended one.”

Lastly, let me add that central bank purchases of risk assets do not extinguish credit and term premia. They instead pass both on to taxpayers in the form of a contingent tax liability. To argue that the “unlimited funds” of the ECB makes it “unique” absorbing risk asset losses is to confuse its supply of financing with its capital. The capital comes from the taxpayers, not from thin air.

Arash

I know it’s late to continue the discussion. I used the time to revise my paper, also because David’s comments made me think. I still disagree with him, but I tried to be more explicit why IMHO Eurobond-financed purchases are not equivalent to OLR-purchases (p. 6).

I agree that the term LOLR meant something very different. I have no problem to name it differently; this is just about semantics; I took over the currently circulating phrase.

I have no idea what this means: “the EU as a whole is not budget constrained” Of course it is. On nominal level, it is constrained by the ECB; On the real level, by resources and productivity.

This is all wrong on two counts:
1. The ECB is one of the main culprits in allowing it to happen in the first place. Any institution overseeing a multi trillion failure should face closure. Not more power.
2. If the ECB backs up the Euro itself, this implies closer European integration. This is against the wishes of the Europeans. In fact: there is every reason to believe that the Eurocrats are using this crisis to get just that. A federalized Europe, including Fiscal Union is their dream.